Strong Job Creation, Weak Stock Market

The stock market’s weak reaction to Friday’s strong jobs report shows how uncomfortable investors have become about taking risks.

The report showed that April job-creation was the highest in more than a year, while unemployment fell sharply to 6.3% from 6.7%.

Stocks greeted that news with across-the-board declines Friday, including a 46-point drop in the Dow Jones Industrial Average to 16512.89. On Wednesday, the Dow had closed at a record high for the first time this year. Since then, it has pulled back and is now once again down slightly (0.4%) for 2014.

The problem is the one that has plagued stocks since the Dow’s 26% gain last year: a concern that they have risen too far, too fast, and that the economic and corporate-earnings outlooks aren’t strong enough to push them much higher now. For all its strong job-creation news, the jobs report also showed soft wage growth and a lot of people abandoning job searches.

A significant stock upturn will take more than good job creation, said Scott Clemons, chief investment strategist at Brown Brothers Harriman Private Banking, which oversees $28 billion in New York.

“It will take some catalyst, a genuine acceleration in economic activity or a sign that corporate America can expand profit margins from already record-high levels. I am hard-pressed to see a whole lot of catalysts,” Mr. Clemons said.

Some investors think this year’s weak start is an over-reaction, and that stocks will resume their gains in the coming months. They note that other worries, such as Russian military activity along its borders with Eastern Europe, could be holding markets back. If those worries fade, stocks could benefit. Right now, however, financial markets are showing more concern than excitement.

Mr. Clemons said his firm has gradually reduced exposure to U.S. stocks, boosting cash levels to as much as 20% from the normal 3% to 5%. He says stocks still look expensive, with the S&P 500 stock index at 17 times its companies’ earnings for the past year, above the average of 15.

He doesn’t forecast a bear market, meaning a decline of 20% or more. But he says a 10% to 15% decline is coming and he is keeping the cash ready to invest after that. “The likelihood of a correction is high,” he said.

Of course, the market rarely falls heavily when people expect it; big declines tend to come when investors are excessively optimistic, not nervous and building cash.

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One sign of the current worry is the strength of U.S. Treasury-bond prices. In times of economic optimism, investors normally buy risky assets like stocks, not safe Treasury bonds.

The demand for Treasury bonds is all the more remarkable because the Federal Reserve is ending the Treasury-bond-buying program it has used to keep interest rates low. That normally would reduce Treasury demand and push yields higher. Instead, Treasury prices have risen and yields declined.

The yield of the benchmark 10-year Treasury bond fell to 2.59% on Friday, its lowest level since Feb. 3. Some of the demand for Treasury bonds is a flight to safety spurred by the Russia fears. But Treasury yields have been falling and prices rising since late March. Russia is one part of the reason and economic uncertainty is another.

David Kotok, chairman of Cumberland Advisors, which manages more than $2 billion in Sarasota, Fla., is betting that the worries about Russia and about U.S. growth will diminish in coming weeks. With monetary policy still exceptionally easy, Mr. Kotok figures that stocks have lots of room to keep rising.

“In general, we are nearly fully invested in stocks,” he said, meaning he hasn’t reduced his holding as Mr. Clemons has.

He isn’t optimistic about Treasury bonds. As the current fears wane, he says, money will come out of safe havens, pushing bond prices down and yields up.

That shift to higher yields, says Don Rissmiller, chief economist at Strategas Research Partners in New York, could pose its own problem for U.S. markets.

With job-creation strengthening and unemployment falling, Mr. Rissmiller says, the next thing for investors to worry about will be inflation. Inflation right now is running well below the Fed’s 2% target, but markets trade on expectations for the future, not present conditions.

Investors are beginning to look ahead to what happens in the latter part of the business cycle, when the Fed starts pushing interest rates higher to prevent inflation, he said. Stocks can continue to rise in the first part of that process, but history suggests that the gains can be harder to achieve.

“We have hit an inflection point,” Mr. Rissmiller said. “I do think this is a potential speed bump for markets. It is hard to see how the Fed gets more helpful to the markets” than it is now. The next thing for investors to worry about is the Fed becoming less supportive, he said.

Mr. Rissmiller also isn’t predicting a bear market. He says that investors could well get past any concerns about inflation and the Fed, as they got past jitters last spring about the Fed’s plans to end its bond-buying program. But he views this as one more worry for investors to struggle with, in a year when markets seem to face no shortage of them.